Gift of real estate - tax ramifications for 2 properties

I could use some advice on the following situation. I've included what I think are the basis and tax ramifications below, please let me know if you agree with me, or if you think I am missing something:

There are two parties:
Daughter (D) - My client
Father (F) - Father of my client

Backstory:
F bought property #1 for D to live in, and paid cash. The cost of the property was 300K. The stipulation was that D would pay interest at around 4% of what the property was worth until she could buy the property in the future. D has lived in the property for 5 years, and paid interest to F. The property is now worth approximately $675K.

F bought property #2 for D to manage as a rental. The cost of the property was $150K 3 years ago, and it is now worth approximately $300K. A mortgage was taken out on the property, which now has a balance of $140K. F never made any money off of the rental, although it does generate rental income. He want's off of the mortgage, and wants to sell it to D for the remaining balance of the mortgage.

Situation:
D has received approval for a mortgage of $475K on property #1, and is ready to close. This money will go to pay off the original cost paid for property #1 by F ($300K). F plans to use the remaining money to pay off the mortgage on property #2, and then gift property #2 to D

Basis for D & Tax Ramifications for F
Property #1 -
D is in essence purchasing property #1 for $475K. Since F's basis in the property is approx $300K (original purchase price, no depreciation), and D is purchasing it for $475K, the greater of the two, $475K, will be D's basis in the property #1.

F will pay capital gain taxes on the difference between the sales price and his cost, approx $175K ($475K - $300K)

F will have to file a gift tax return and include the difference in the purchase price and FMV of the property, $200K (675K - $475K)

Property #2 -
Since F is only gifting D this property (not selling it per se), D's basis in property #2 will be the adjusted basis of the property at the time of the gift (lets say $150K, assuming no depreciation)

F will not pick up any gain because this is 100% a gift.

F will have to file a gift tax return and include the adjusted cost basis of the property, 150K

Potential Alternative
Obviously F is not looking forward to paying capital gains on $175K on property #1. As an alternative, even though all of the money is being paid through Property #1, is it possible to "allocate" 150K of that money and consider is as the cost of sale for property #2. If that was possible...

D would have a basis in property #1 of $325K ($475K sales price less $150K allocated to property #2)
F would only pay $25K in capital gains on property #1 ($325K - $300K)
F would file a gift tax return and include a gift amount of $350K for property #1 ($675K - $325K)

D would have a basis in property #2 of $150K (allocated purchase price)
F would pay zero in capital gains ($150K purchase less $150K adjusted basis)
F would file a gift tax return and include a gift amount of $150K for property #1 ($300K FMV - $150K adjusted basis)

That was a lot. Sorry if any of the #s are confusing, I know some of them are similar. Let me know if you need any clarification.

Thanks for looking!

First reaction, father has a good eye for real estate value. Nice increases. Rather than solve your many questions globally, let's look at them individually, at least for now.

Are these arrangements in writing or are they informal understandings?

Is the 4% "interest" that D paid to F (a)rent, or (b)interest, on the theory D was beneficial owner? Who paid for taxes, maintenance, insurance, repairs? Why was there no depreciation on property 1? How did F report it, if at all? BTW, 4% of "what the property was worth" is vague. Worth at purchase or adjusted periodically? How much is D paying now to "buy" property 1?

On property 2, what do you mean that F never made money on it? Cash on cash, or taxable income? How was it reported by F? Depreciation claimed?

Clarify what's to happen in property 2. Is it a gift of the property subject to the mortgage, or a sale at the mortgage balance, or doesn't it matter?

Your alternative seems feasible to me, but others may disagree.

Kind of depends on how F treated payments by D. If you take the position that F bought property 1 and immediately sold to D with a 300K balloon and reported the $12K a year as interest income you have a part gift part sale on property 2 .

First reaction, father has a good eye for real estate value. Nice increases. Rather than solve your many questions globally, let's look at them individually, at least for now.

Are these arrangements in writing or are they informal understandings?

Is the 4% "interest" that D paid to F (a)rent, or (b)interest, on the theory D was beneficial owner? Who paid for taxes, maintenance, insurance, repairs? Why was there no depreciation on property 1? How did F report it, if at all? BTW, 4% of "what the property was worth" is vague. Worth at purchase or adjusted periodically? How much is D paying now to "buy" property 1?

On property 2, what do you mean that F never made money on it? Cash on cash, or taxable income? How was it reported by F? Depreciation claimed?

Clarify what's to happen in property 2. Is it a gift of the property subject to the mortgage, or a sale at the mortgage balance, or doesn't it matter?

Your alternative seems feasible to me, but others may disagree.

All great questions. I was trying to simplify the details because it was a long post, but maybe that wasn't the greatest idea. Here are the answers to your questions:

1) Informal agreement. D thought they had something written up but she cannot find it

2) Here is one of the contentious positions. D thought she was paying simple interest for use of the property, but talking to the father's CPA, they have been taking it as a rental property. We were originally working on the theory of this being a lease to own situation (which would have made all of this a lot more simple), until we found out it was being taken as a rental property. I'm still back and forth on how to treat this.

3) D paid F for taxes & insurance, D paid for everything else directly

4) There is depreciation because it is being taken as a rental F, I was just trying to simplify the #'s because I didn't think it was relevant

5) F reported as a rental, D did not know about this until we got on the phone with F's CPA

6) 4% of original purchase price

7) The sales contract is for $475K. The house is worth $675K

8) F never made money on property #2 because D managed it. Any positive income from the property was paid out to D as a management fee, so it should have shown as negligible on Sch E. Yes, depreciation was taken.

9) F really just wants off the mortgage for property #2, and wants it off his tax return. He doesn't care how that is accomplished, as long as the mortgage is paid off and its off his tax return.

Kind of depends on how F treated payments by D. If you take the position that F bought property 1 and immediately sold to D with a 300K balloon and reported the $12K a year as interest income you have a part gift part sale on property 2 .

This was what we were hoping for. Even better if it had been set up as a lease to own originally. The simple $12K year interest was how D thought it was being handled, until we got on the phone with F's CPA yesterday and found out they've been taking it on Schedule E.

If they take out a mortgage on the property A saying that the entire 675k is used to purchase one property, and then you try to allocate part of it to another property, you are essentially committing fraud. You are really buying two buildings with a mortgage on one, most likely with the bank thinking the loan is for a primary residence. FHA loan, etc.

Essentially, the house was sold on day 1 with a land contract with interest only payments. What they are doing here is refinancing the home. Now, if you want to take a cash out refinance to buy the second property, and clear the original "contract" with the father, I think that would be ok. But, you would still run the gambit of the mortgage interest would not all be deductible as mortgage interest on the primary home (which you most likely wouldn't want to deduct it like that anyhow).

If the interest payments were incorrectly reported on Sch E, he could amend his returns and pay the difference. (Did he depreciate the house?)

Was she claiming the real estate tax and "interest" as itemized deduction all along?

Couldn't they just take out a investment property mortgage on property 2 with a gift of equity as down payment instead of trying property 1 mortgage fraud?

**I am not a lawyer**

Basically the parties have to agree on treatment. If not for the existence of the sale contract there would be nothing wrong with two part sale part gift transactions.

If they take out a mortgage on the property A saying that the entire 675k is used to purchase one property, and then you try to allocate part of it to another property, you are essentially committing fraud. You are really buying two buildings with a mortgage on one, most likely with the bank thinking the loan is for a primary residence. FHA loan, etc.

Essentially, the house was sold on day 1 with a land contract with interest only payments. What they are doing here is refinancing the home. Now, if you want to take a cash out refinance to buy the second property, and clear the original "contract" with the father, I think that would be ok. But, you would still run the gambit of the mortgage interest would not all be deductible as mortgage interest on the primary home (which you most likely wouldn't want to deduct it like that anyhow).

If the interest payments were incorrectly reported on Sch E, he could amend his returns and pay the difference. (Did he depreciate the house?)

Was she claiming the real estate tax and "interest" as itemized deduction all along?

Couldn't they just take out a investment property mortgage on property 2 with a gift of equity as down payment instead of trying property 1 mortgage fraud?

**I am not a lawyer**

Agreed with you on the first part of your assessment. Of course as the CPA I'm getting included on the back end when everything is already in motion.

The daughter does not know what was actually included on the father's tax return. F's CPA did tell us the property was being included on Sch E, and was frankly not very forth coming with details on the conference call, but I understand that as technically D is not his client. I believe the father was taking all of the deductions.

Basically the parties have to agree on treatment. If not for the existence of the sale contract there would be nothing wrong with two part sale part gift transactions.

Thanks

Also, no one has explicitly said I am wrong in my interpretation of the situation, so at least I think I'm heading in the right directon.

As I said before, if you "allocate" any portion of the mortgage on home 1 to home 2, then you/your client may be in the realm of committing mortgage and/or tax fraud. They are most likely swearing on the mortgage application by signing it that the proceeds of the loan are being used to buy home 1. Consult a lawyer would be my advise.